Creating a Debt Reduction Strategy
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If you have a significant amount of debt – whether from credit cards, a mortgage, an auto loan, student loans or otherwise – chances are you've thought about the best ways to reduce what you owe.
Maybe your debt has strained your credit scores and you need to work on improving them. Maybe you'd like to enhance your credit history before applying for a mortgage or borrowing money for a child's education. Whatever your reason for paying down debt, success starts with understanding your current financial situation and building a strategy to follow moving forward.
How much debt do you have, and what kind is it?
The amount you owe and the type of debt you carry will have an impact on your credit scores and credit reports from the three nationwide consumer reporting agencies (Equifax, Experian and TransUnion).
Debt is typically divided into “good debt” and “bad debt.” Historically, debt associated with a mortgage, a business or student loans has been considered good debt, because the money you spend on your housing, livelihood or education comes with the expectation that you're improving your financial outlook. Your home, for example, will likely appreciate in value over time, and a good education will give you the skills needed to move up the corporate ladder, thereby increasing your earning potential.
Bad debt, on the other hand, is generally considered any debt associated with purchases that won't improve your long-term value. This includes obvious items such as credit cards, personal loans and payday loans, but can also include your car loan, since new cars generally depreciate upon purchase.
When setting up a repayment plan, take stock of all your debts, calculate the total and separate them into good vs. bad. Also, pay attention to the interest rate on each existing line of credit. It's good practice to pay off bad debts with high interest rates first, because creditors are less skeptical of good debt remaining on your credit reports. Of course, you still need to make on-time payments toward the good kinds of debt, but a mortgage that allows you to write off your interest payments at tax time is not as detrimental to your overall credit health as, say, a balance on a high-interest credit card.
When you've taken stock of the debts you have and how they're viewed by lenders, you can start to formulate ways to pay down what you owe. Begin the process by making a budget and committing to living within your means. If, for example, your monthly income is $3,000, make sure your expenses, including what you'll use to pay down your debts, are less than that.
Now you can decide which debt you want to tackle first. If you're looking for an easy morale boost, you might start with a debt that you can eliminate quickly, such as a credit card with a low balance or the remainder of a small loan. Crossing a debt off your list can build your confidence and help the overall effort gain momentum. This strategy is commonly known as the snowball method.
Another approach is to list your debts according to interest rate, highest to lowest, and start at the top of the list — often called the avalanche method. By tackling your high-interest debts first, you will eliminate the ones that cost you the most each month.
For example, say you owe $500 on each of two credit cards. Card A has an interest rate of 14 percent, while Card B charges 21 percent. If you make monthly $100 payments to Card B (the one with a higher interest rate) while making minimum payments on Card A, you will end up paying $2,652 in principal and interest rather than $2,723 if you had paid them off in the reverse order.
Whichever strategy you choose, be sure to put any extra money — such as a bonus, tax refund or side-gig income — toward your debt payments.
When reducing debt and rebuilding damage done to your credit scores, long-term strategies are equally important. This is where debt consolidation, debt management plans, advisory services and other third-party assistance can come in handy.
You might begin by seeing if you qualify for a hardship debt management plan. Also known as a DMP, these formal agreements are made between the debtor, their creditor(s) and a credit counselor. The debtor agrees to make a single recurring payment (e.g., monthly) to the credit counselor, whose firm divides that payment among the creditors on an established schedule.
Credit card issuers sometimes offer concessions — such as reducing interest rates, modifying repayment terms or waiving late or over-limit fees — to debtors who enter into a DMP. Before taking this step, however, you should be aware that a DMP will not directly affect your credit scores, but it could make future borrowing more difficult because it tells creditors that you were unable to pay off your debt in full or on the agreed-upon date.
In addition to reducing your debt, short- and long-term plans will help you to avoid being turned over to a collection agency. Things like unresolved charge-offs (when a creditor writes off your debt after several months of nonpayment), collection accounts, or court judgments against you based on accounts that you didn't repay can hold you back from rebuilding your credit scores as quickly as you would like.
If you do end up in collections, it is important to know your rights. The Fair Debt Collection Practices Act is a federal law that spells out what collectors can and cannot do, and the Consumer Financial Protection Bureau has a great deal of information on its website about how the process works. You can also read more on the Federal Trade Commission's website.